The Cause and Consequences of the Retail Apocalypse

Private equity firms overburdened businesses with debt, and now workers are paying the price. Will policymakers do anything about it?

November 14, 2017

The Macy’s near my house is closing early next year. The mall where it’s located has seen less and less foot traffic over the years, and losing its anchor store could set off a chain reaction. Cities across the country are facing this uncertainty, with over 6,700 scheduled store closings; it’s become known as the retail apocalypse.

This story is at odds with the broader narrative about business in America: The economy is growing, unemployment is low, and consumer confidence is at a decade-long high. This would typically signal a retail boom, yet the pain rivals the height of the Great Recession. RadioShack, The Limited, Payless, and Toys“R”Us are among 19 retail bankruptcies this year. Some point to Amazon and other online retailers for wrestling away market share, but e-commerce sales in the second quarter of 2017 only hit 8.9 percent of total sales. There’s still plenty of opportunity for retail outlets with physical space.

The real reason so many companies are sick, as Bloomberg explained in a recent feature, has to do with debt. Private equity firms purchased numerous chain retailers over the past decade, loading them up with unsustainable debt payments as part of a disastrous business strategy.

Billions of dollars of this debt comes due in the next few years. “If today is considered a retail apocalypse,” Bloomberg reported, “then what’s coming next could truly be scary.” Eight million American retail workers could see their careers evaporate, not due to technological disruption but a predatory financial scheme. The masters of the universe who devised it, meanwhile, will likely walk away enriched, and policymakers must reckon with how they enabled the carnage.

Sears, once a giant of America’s consumer-led economy, was run into the ground by hedge-fund king Eddie Lampert. In 2005, Lampert, a former Yale roommate of Treasury Secretary Steven Mnuchin, arranged the merger of Sears with discount retailer Kmart, and immediately started shifting revenue to shareholders. He spent $6 billion on stock buybacks to reward investors and prop up the share price.

More important, Lampert personally lent billions to Sears Kmart, increasing corporate debt. As in-store sales lagged, Sears sold off major assets like Craftsman brand tools and Land’s End outdoor equipment to service the loans. Lampert also split ownership of 266 Sears and Kmart buildings into a real estate investment vehicle called Seritage. Last year, Sears and Kmart stores paid $200 million in rent on these properties they once owned, eating up operating revenue.

As Sears closes hundreds of stores and considers bankruptcy, Lampert will likely come out ahead. He enjoyed fees from all the lending to Sears, and he’ll recoup more money in any restructuring, even if Sears has to sell off inventory to do it. As a shareholder of Seritage, Lampert’s hedge funds can profit from higher rents charged to new retail outlets that move into the shuttered Sears locations.

The mismanagement of Sears reflects an ongoing pattern: private equity takeover artists that benefit from hobbling the companies they purchase. Golden Gate Capital and Blum Capital, the two firms behind footwear chain Payless, paid themselves $700 million in dividends in 2012 and 2013, all on the back of the company. Payless filed for bankruptcy this year, closing 400 stores. Toys“R”Us filed for bankruptcy in September, unable to sustain between $400-$500 million in annual interest payments on $5.2 billion in long-term debt. Buyout managers, including Bain Capital and longtime firm Kohlberg Kravis Roberts, stripped out nearly $2 billion in cash while debt levels rose.

This is a robbery in progress. Private equity firms borrow massively to buy companies, and use corporate cash reserves to pay themselves back. Workers who supply the value to the business see nothing; in fact, to service the debt, companies usually cut staff. When the retailer collapses under the borrowing weight, all workers lose their jobs. And even when sales go up, like they have by 5 percent annually in the toy sector over the past five years, dominant toy sellers like Toys“R”Us cannot compete because of the debt burden. The company’s profitability was increasing when it filed for bankruptcy.

Private equity firms counter that their business model returns companies to fiscal health through superior management. But the retail apocalypse reflects an epic miscalculation. Typically retail firms roll over debt to buy time, but interest rates have risen since the last set of buyouts several years ago, making that prospect more expensive. The overleveraged companies are finding it hard for anyone to agree to refinance.

As a result, delinquent payments on shopping centers and other commercial real estate have spiked, as high as one-quarter of all loans in some parts of the country. A hundred thousand retail jobs were lost from October 2016 to April 2017; in June, 1,000 stores closed in a week. And this will get worse: Only $100 million in retail debt came due this year, but there’s $1.9 billion next year and $5 billion on average due between 2019 and 2025. That threatens the retail sales and cashiers who make up 6 percent of the entire U.S. workforce, a total of 8 million jobs. These workers are not confined to any one region; the entire country will share in the pain.

Policymakers must also be held responsible for this looming nightmare. Our tax code privileges debt by making corporate interest payments tax-deductible. So the private equity kingpins who pillage companies and walk away get tax subsidies to pull it off, and this incentivizes them to borrow even more to run the game again.

The Republican tax plan actually recognizes this. The House bill proposed a cap on the deductibility of interest payments over 30 percent of a company’s earnings; the Senate bill defines earnings in such a way to reduce that cap even further. This would discourage some debt-fueled buyouts, and private equity firms are screaming about it.

However, the GOP left a gaping loophole: Real estate companies are exempt from this cap. This would benefit President Donald Trump’s family business, but it could also help private equity firms that split the operating side of the businesses they buy from the property side, as Sears did. They could put all the borrowing onto the property side and continue to deduct the interest.

What we need to do is look at these asset-stripping schemes more skeptically. The Securities and Exchange Commission can and should police the designed-to-fail corporate bonds that proceed from these leveraged buyouts. The banks that underwrite the deals should also be slapped for earning fees off the misery of an entire industry.

Instead, the Trump administration is likely to continue aiding wealthy financiers through regulatory neglect. Just last week, Comptroller of the Currency Keith Noreika broke with a years-long crackdown on high-risk corporate lending, signaling that more debt should be issued. We don’t have regulators willing to take action to protect workers, investors, and the economy. That’s too bad, because private equity is accelerating a decline that will be felt by millions in every major city. Inaction is a choice. This apocalypse didn’t have to happen.